Seek a Predictable Regular Return: The Autocall - dummies

By David Stevenson

Over the years financial product designers and marketing types in the UK have constantly tinkered with the basic zero structure, with perhaps the most important innovation being the autocall (or kick out plan).

The basic idea behind an autocall is nearly as simple as the zero – an annual return in exchange for taking some risk:

  1. You hand over, say, £100 per share or unit, potentially for a period of up to five years. The level of the underlying or reference index – in this case, the S&P 500 – is noted at issue.

  2. The issuer looks back at that underlying index at the end of year one to see whether it increased (any increase, no matter how small, is relevant) or remained stable. As long as the underlying index hasn’t dropped in value, the structure calls: that is, it pays out an agreed upfront return of 5 per cent for the year.

  3. Your £100 is now £105 and the autocall matures – that is, closes or winds up.

What happens, you may ask, if the underlying index doesn’t advance but falls back? Well, the barrier on a typical autocall is usually set at 50 per cent (at which point your capital is at risk), but if the index has fallen by, say, 10 per cent you don’t need to panic.

Your autocall simply rolls on to the next year, to the second anniversary of the fund, when again you see whether the underlying index has advanced from the initial level. If it has, you receive a return for both years, in other words, 10 per cent or £110.

Every year over the next five or six years you’re presented with a chance to receive an annual income, as long as the underlying index stays stable or advances.

If the index doesn’t advance at all over the full five years (based on the initial level of the S&P 500) you simply receive back your initial investment of £100 as long as the barrier hasn’t been breached (that is, the S&P 500 hasn’t fallen by more than 50 per cent).

Returns from autocalls are, like zeros, regarded as capital gains, which can be advantageous for certain investors. Autocalls also carry with them the same set of risks as a zero: counterparty risk of the bank issuer going bust; the barrier being breached in a nasty market downturn; and the opportunity cost of markets rising and of dividends not being paid.

Yet the intrepid investor also receives some equally obvious upsides including a potentially steady 5 per cent return plus a capital gain.

Autocalls have also been tweaked over the years, with a defensive version perhaps the most noteworthy. The defensive autocall is structured exactly like a conventional autocall with annual call dates and a barrier, but with one key difference – you can receive an annual call return even if the market you’re tracking has fallen in that year.

Imagine for one moment that the FTSE 100 is at 6,000 when a defensive autocall is issued with a 10 per cent annual return. The defensive version may still make that 10 per cent payment in one year’s time even if the underlying index falls by no more than 10 per cent.

Therefore, as long as the FTSE 100 index is at 5,400 or more, you get a 10 per cent annual return; that is, you may make a 10 per cent positive return even if the stock market falls by 10 per cent over the same period.

The call level used to trigger annual payments may in fact keep on falling every year over the next five years, perhaps settling at just 50 per cent of the initial level of 6,000 for the FTSE 100; that is, it pays out a positive return of 10 per cent per annum even if the FTSE 100 index is at 3,001.